Investing, Asset Allocation, Economics & the Search for the Bottom Line

US Business Cycle Risk Report | 20 April 2018

The threat of a global trade war is a risk factor for the global economic outlook, warned the managing director of the International Monetary Fund on Thursday. But in the weeks since President Trump rolled out tariffs on Chinese imports – and China responded in kind – nothing much has changed in the hard data as it relates to the US macro trend.
The probability that a new recession is near for the US remains virtually nil. That could change, of course, if trade restrictions expand beyond the relatively minimal tariffs announced so far. At the moment, however, a downturn triggered by a trade war appears to be a low-probability event, based on the numbers published to date.

By contrast, headwinds tied to growth may be a bigger threat in the months ahead. With the US economic expansion in its ninth year, the Federal Reserve remains on track to push interest rates higher. It remains to be seen if tighter monetary policy will choke off growth, but the case is still solid for expecting output to rise in the foreseeable future.

Next week’s preliminary estimate of first-quarter GDP growth, however, is set to decelerate to 2.1%, according to this month’s survey of economists via The Wall Street Journal. That’s well below the 2.9% gain in the previous quarter.

Growth may be on track to downshift, but the projections published to date are still strong enough to keep the economy from falling off the business-cycle cliff. Meanwhile, the Capital Spectator’s estimate of recession risk for the US equates with a near-zero chance that a new downturn started last month, based on a diversified set of economic indicators. (For a more comprehensive review of the macro trend on a weekly basis, see The US Business Cycle Risk Report.)

The upbeat profile implies that Monday’s release of the Chicago Fed National Activity Index for March will confirm that recession risk remained low last month.

Aggregating the data in the table above translates into a strong positive trend overall. The Economic Trend and Momentum indices (ETI and EMI, respectively) remain well above their respective danger zones (50% for ETI and 0% for EMI). When/if the indexes fall below those tipping points, the declines will mark clear warning signs that recession risk is elevated and a new downturn is imminent. The analysis is based on a methodology that’s profiled in my book on monitoring the business cycle.

Translating ETI’s historical values into recession-risk probabilities via a probit model also points to low business-cycle risk for the US through last month. Analyzing the data in this framework indicates that the odds remain effectively zero that NBER will declare March as the start of a new recession.

For insight into the near-term outlook, consider how ETI may evolve as new data is published. One way to project values for this index is with an econometric technique known as an autoregressive integrated moving average (ARIMA) model, based on calculations via the “forecast” package in R. The ARIMA model calculates the missing data points for each indicator for each month — in this case through May 2018. (Note that January 2018 is currently the latest month with a full set of published data for ETI.) Based on today’s projections, ETI is expected to remain well above its danger zone through next month.

Forecasts are always suspect, but recent projections of ETI for the near-term future have proven to be reliable guesstimates vs. the full set of published numbers that followed. That’s not surprising, given ETI’s design to capture the broad trend based on multiple indicators. Predicting individual components, by contrast, is subject to greater uncertainty. The assumption here is that while any one forecast for a given indicator will likely be wrong, the errors may cancel out to some degree by aggregating a broad set of predictions. That’s a reasonable view, based on the generally accurate historical record for the ETI forecasts in recent years.

The current projections (the four black dots in the chart above) suggest that the economy will continue to expand. The chart also shows the range of vintage ETI projections published on these pages in previous months (blue bars), which you can compare with the actual data (red dots) that followed, based on current numbers.

For more perspective on the track record of the forecasts, here are the previous business-cycle risk updates for the last three months:

Note: ETI is a diffusion index (i.e., an index that tracks the proportion of components with positive values) for the 14 leading/coincident indicators listed in the table above. ETI values reflect the 3-month average of the transformation rules defined in the table. EMI measures the same set of indicators/transformation rules based on the 3-month average of the median monthly percentage change for the 14 indicators. For purposes of filling in the missing data points in recent history and projecting ETI and EMI values, the missing data points are estimated with an ARIMA model.